January 5, 2010
Because of the volatility smirk, replicating the strategy using only call options is not very attractive because we end up paying too much for the $100 call. This result suggests that it is the volatility smirk that is making costless collars relatively unattractive at current prices, rather than a violation of put-call parity.
The implied volatility for options with strike prices well below the current level of the market is quite high (we are concerned mainly with puts, of course) – which means that costless collars require that we give up a lot of upside to get protection from large downward market moves. Again, this is not surprising given the recent market declines and recent periods of very high volatility. Investors are far more concerned about the potential for large losses than they are optimistic about the potential for large gains. This is not a permanent situation, but illustrates how the relative attractiveness of the costless collar may evolve over time.
Some real-life data
As mentioned earlier, there is a mutual fund that is intended to implement costless collars as a mechanical strategy (COLLX). This fund has less than one year of history. It is interesting, however, to compare the daily returns from COLLX since its launch in mid-2009 to the S&P500 and to a 50/50 portfolio (see graph below).
The range of performance of COLLX since launch looks remarkably like a 50/50 portfolio, and we do not see the “floor” and “ceiling” effects that would be expected based on the idealized results of costless collars shown in the Monte Carlo simulations. This is due to the fact that this fund can invest in a range of stocks and ETFs and can purchase collars at a range of strikes.
The idea of implementing costless collars on a range of individual holdings has additional implications that are beyond the scope of this discussion.
Final thoughts
The most attractive element of collar strategies is their ability to remove the impact of really bad events on a portfolio with the purchase of a put option. The ability to finance the purchase of the puts by selling off some of the upside potential from the portfolio is appealing, and avoids having to sell existing holdings and retains the dividends as a stream of income.
The potential payout depends on the actual prices at which the puts and calls can be executed. In the current market, the price that we can get for the calls is low relative to the price that we must pay for the puts. This is not a reflection of a disconnect between call prices and put prices – we see the same effect if we create a synthetic position that matches the costless collar using two call options. The challenge in making the costless collar attractive is a direct result of the volatility smirk: people are currently willing to pay a lot for downside protection.
Current market conditions provide just one example of when a costless collar will look less attractive. Even at current prices, a costless collar will look attractive for some investor due, for example, to tax issues associated with selling current holdings. Furthermore, we have examined the case for the collar applied to the S&P500. With other indices or portfolios, the current prices of options may be more attractive.
For income-oriented investors who are concerned about hedging near-term downside potential, the very limited upside available at current options prices may not be too great a concern. Even at current prices, a costless collar strategy applied to a portfolio of high-yield stocks can be quite attractive. With stocks like Verizon (VZ) and Con Ed (ED) having dividend yields at 5.7% and 5.1% (respectively), locking in the dividend with a collar looks quite attractive, and the relative balance of upside given up to get the downside protection is less of a concern. ED is at about $46 as of this writing. The January 2011 $45 call option on ED is at about $2.80 and the $40 put option is at about $1.80. If you sell the calls and buy the puts, you keep $1 per share in net premium, but that is offset by the fact that the call option is about $1 ‘in the money’ – the call has a strike of $45 and the current price is $46. This position won’t make anyone rich, but it does allow an investor in ED to cushion the potential downside of a big decline.
Potential investors must understand that the use of a costless collar strategy has a complex impact on the portfolio. Simply looking at the change in expected return and standard deviation in returns is insufficient, because the portfolio may no longer have normally distributed returns on any specific time scale.
After a two-year period in which the market has reminded us that a 40% decline in a year is a real possibility, the ability to shape portfolio returns to create a floor on absolute losses is very attractive. Particularly for retirement planning, the potential increase in happiness that a windfall could provide is far less significant than the potential for misery from a large loss.
Geoff Considine is the founder of Quantext (www.quantext.com) a firm which sells Monte Carlo – based portfolio management software. Geoff has recently published an e-book on the use of options in wealth management.
Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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